Jul222015

Dodd-Frank vastly improves the mortgage lending market

Dodd-Frank effectively regulates the mortgage market and greatly restricts the proliferation of unstable loan products that harm both borrowers and lenders.

power_to_the_bankersIn the post, Dodd-Frank prevents lenders from inflating another bubble, I detailed the impact Dodd-Frank had on the housing market. Today, I want to look at the impact Dodd-Frank has on the mortgage market, the mechanism by which Dodd-Frank prevents future housing bubbles.

When Congress took on the task of regulating the excesses of the mortgage industry, it ostensibly wanted to prevent a recurrence of the housing bubble. To that end, they passed the Dodd-Frank finance reform. One of the provisions of Dodd-Frank was to establish a “qualified mortgage” that establishes the parameters of what constitutes a “safe” mortgage product unlikely to cause another housing bubble, soliciting advice from various sources to come up with an appropriate set of standards.

In Preventing the Next Housing Bubble, the final chapter of the book, I addressed what it would take to prevent another catastrophe like we witnessed over the last decade. It has a series of parameters similar to the recently issued guidance on what constitutes a qualified mortgage:bankers_bonus_party

Loans for the purchase or refinance of residential real estate secured by a mortgage and recorded in the public record are limited by the following parameters based on the borrower’s documented income and general indebtedness and the appraised value of the property at the time of sale or refinance:

  1. 1. All payments must be calculated based on a 30-year fixed-rate conventionally-amortizing mortgage regardless of the loan program used. Negative amortization is not permitted.
  2. 2. The total debt-to-income ratio for the mortgage loan payment, taxes and insurance cannot exceed 28% of a borrower’s gross income.
  3. 3. The total debt-to-income of all debt obligations cannot exceed 36% of a borrower’s gross income.
  4. 4. The combined-loan-to-value of mortgage indebtedness cannot exceed 90% of the appraised value of the property or the purchase price, whichever value is smaller except in specially sanctioned government programs.

The key provisions are documenting income and requiring qualification based on an amortizing mortgage and a reasonable percentage of a borrower’s income. Liar loans and the Option ARM were the primary culprits that inflated and destabilized the housing market, and an abdication of debt-to-income standards ensured these loans would fail. The new standards for a qualified mortgage successfully addressed these issues.first_banker

The success of Dodd-Frank is also the source of the political pushback from lenders chaffing against the restrictions on business the law imposes. Like any other special interest, lenders will fight even the most common sense restrictions on their behavior if it reduces their revenue.

How Dodd-Frank changed housing, for good and bad

Diana Olick, July 16, 2015

The effect of loose lending during the last housing boom was abundantly clear: Nearly 8 million U.S. homes fell into foreclosure. The response was a slew of new lending rules under the Dodd-Frank financial reform law, and the result was a credit lockdown that continues today, nearly five years after the legislation was enacted.

Lenders and their lobbyists want us all to forget the pain caused by their failure with financial innovation. Dodd-Frank we necessary to police an industry incapable and unwilling to regulate itself.

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“For lenders this is all about paperwork, verification and doing a lot of the grunt work that was ignored or passed over before the crisis,” said Jaret Seiberg, a managing director at financing firm Guggenheim Securities.

The law is about much more than just paperwork. To portray it that way misses some of it’s most vital features. The details of the loan terms buried in that paperwork is also carefully scrutinized and regulated by Dodd-Frank.tomorrows_bankers

The rules fill thousands of pages and have cost lenders millions of dollars in labor and software to revamp their systems in compliance, but at face value, they’re pretty simple.

A law needs to be simple to be effective. This law is.

Highly risky loan products, like negative amortization mortgages, are now banned.

As they should be. Options ARMs were the loan most responsible for inflating house prices.

Borrowers must document their employment and debt levels.

Liar loans were the worst financial innovation of the housing bubble because these loans caused investors in mortgage-backed security pools to question the financial representations of all borrowers in all loan pools. This doubt about the veracity of loan qualifications spread from the pools that specifically allowed liar loans to all MBS pools, causing investors to abruptly stop buying mortgage-backed securities. This was an essential change.eliminate-lending-standards

Lenders must disclose all the costs involved in each loan, and, perhaps most important,lenders must verify a borrower’s ability to repay the mortgage. That last one may sound ridiculous, but it was the fundamental reason for the financial crisis in housing. Borrowers were given loans they could never repay.

To me this is the one that most clearly demonstrates that a government regulator is necessary. Originating lenders pass the risk on to other parties, so they don’t care much whether or not the borrower can repay the loan. The investors should care about this, but they rely ratings agencies and eschew the due diligence that

… Tight credit, though, is blamed for a still-falling homeownership rate, now at the lowest in a quarter century.

impactThe tight credit meme is largely bullshit. (See: Despite industry spin, mortgage lending standards are not tight)

… said Craig Strent, CEO of Maryland-based Apex Home Loans. “It’s not hard to qualify, it’s hard to get through the process because of the massive amounts of additional documentation that is now required.” …

Is it truly burdensome to produce a few important documents to qualify for several hundreds of thousands of dollars in loan money? Given the size of the loan, the paperwork burden is not onerous.

“There are so many ways to make a mistake, and the banks learned from a financial crisis that the regulators will keep coming after you, over and over and over again for these errors,” said Seiberg.

stifleGood! Would it be preferred to let criminals know they can get away with their activities due to lack of enforcement?

The rules may also stifle innovation in mortgage lending.

“It has slowed down lenders from taking chances again. Ultimately that may be good, and maybe that’s what the law was supposed to do, but it is slowing down lending and certainly is making the housing recovery a little bit more difficult because lenders are not jumping in with new products,” said Hsieh.

Yes, this is a feature, not a bug. (See: Promoting financial innovation will result in future housing bubbles)

The home loans being made today are arguably the most pristine in history. New default rates are at record lows. All that, however, comes at a cost to lenders, borrowers and the overall health of the housing market itself.

tarp moneyThe consequences to the housing market include lower but more stable house prices, and that’s a price worth paying to avoid the despair caused by housing busts.

My only fear is that our financial oligarchs will use their lobbyists and campaign cash to buy off enough legislators to overturn the law or relax enforcement. Fortunately, the Democrats foresaw some of this and made the Consumer Financial Protection Bureau financed by the federal reserve and outside the meddling of Congress.

These new mortgage regulations are here to stay, at least for a while. A far larger concern is the lack of enforcement and oversight. And if the issue were left up to the agencies or the federal reserve, that would still be a big concern, but that’s not where enforcement will come from. Civil lawsuits from future loanowners decrying their inability to repay the loans is what will keep lenders in line. Enabling enforcement by individuals and their attorneys, Lenders won’t introduce any unstable financial innovations or face the wrath of millions of aggrieved homeowners.

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